The Importance of Exports

Being the largest export market, the U.S. economic slowdown would inevitably affect the rest of the world. Past statistics confirm such a relationship. For example, as U.S. economic growth dropped from 5.8% to -0.4% in 1974-75, growth of other industrial countries and Asian emerging markets also fell by 5.4 and 3.5 percentage points respectively during the period. In 2001, amid the fall of U.S. economic growth by 2.9 percentage points, other industrial countries and Asian emerging markets also registered declines in GDP growth by 2 and 1.1 percentage points respectively. It is particularly noteworthy that contraction in U.S. imports far exceeded the fall in GDP growth. For example, as U.S. GDP growth dropped by almost 3 percentage points in 2001, imports declined by 6.3%. This suggests that U.S. economic performance, though not the primary factor in economic development of the rest of the world, would still exert non-negligible influence.

Currently, there has been an optimistic view that points to the overall reduced reliance on the U.S. economy, suggesting lower influence from the U.S. On the other hand, China would be in a better shape as internal growth momentum has increased. Some evidence may support such a view. The share of exports to the U.S. in total exports of the Euro Area fell from 17.2% to 14.9% in 2000-2005. In Asia, this trend has been more notable, with the share of exports to the U.S. falling by more than 7 percentage points in Japan and the four dragons, and registering declines in Thailand, the Philippines and India as well. However, China's situation is not that alike. The share of exports and net exports in China's GDP rose from 20% and 1.7% to 36% and 7.8% respectively from 2001 to 2007. As exports to the U.S. has maintained a share of over 20% in China's total exports, its share in GDP reached 7.6% in 2006, compared with the about 3% share of exports to the US of the Euro Area and Japan. This reflects the heavy reliance of China on exports. Besides, China is still more vulnerable to a U.S. economic slowdown compared with other major countries. Increased dependence on exports and the U.S. market also implies higher influence of the U.S. on the Chinese economy then before.

Should China's high growth in exports tumble, impacts would be broad. The trade balance may not vary much as over half of China's external trade is processing trade, with falling exports also driving down imports. Nevertheless, other areas would be affected, e.g. employment. China's export industries have been major employers, with the 10 largest export sectors employing about 51% of labour in manufacturing industries. High correlation between growth in employment and exports can be observed in recent years, e.g. electronics and communications equipment. Amid dim employment prospects, private consumption may face more obstacles. In 2007, retail sales grew by 12.5%, after discounting price changes. This only represented moderate improvement and was still far behind growth in fixed investment and exports. The lagging of consumption in the Chinese economy looks to persist.

Slowing exports momentum would also affect fixed investment, another major growth spot in China. Investment in manufacturing industries has also been largely related to exports. In 2006, urban fixed investment in the 10 export sectors occupied 49% among total fixed investment of the state defined 35 manufacturing industries. While private consumption momentum remains low, exports have contributed to absorb the excess production capacity generated by high investment growth. In case exports grow by less, excess capacity is likely to surface. Investment momentum would then be dented.

Imported and Cost-Push Inflation

The U.S. subprime crisis and economic slowdown have brought about significant loosening of monetary and fiscal policies. These have fuelled the fall of the greenback and added pressure on inflation. Actually, U.S. inflation has rebounded somewhat late last year, giving rise to "stagflation" worries. At the same time, commodities prices have risen, as reflected in the 20% boost in the CRB index since last September. Gold prices rose by 30% and reached historical high while substantial increases can be seen in prices of crude oil, farm products and even the lagging industrial metals. Supply or speculative factors have certainly played their roles, but so have U.S. policies and the weak dollar. As the U.S. has given priority to tackle the economic slowdown, U.S. short-term rates are expected to fall by 100 bp by the end of this year. This may fuel further commodity price hike.

Such an external environment has undoubtedly complicated the inflationary environment of China. The inflationary pressure arisen since last year in China has been food-prices-led. However, there are implications on the trend of overall price performance. The surge in food prices reflects not only temporary shortages, but also the global upward trend as well as rising land and labour costs in the Mainland. In the first three quarters in 2007, year-on-year growth of urban wages reached 19%. Soaring food prices has further added wage hike pressure. Amid efforts to curb wastage, promote environmental and income protection, the resulted cost increase would be long-term and rigid. On the other hand, rising food prices have been fuelling inflation expectations. In Q4 last year, 64.8% respondents expected further price hike in 2008 in the Urban Household Survey, the largest ever recorded. The Central Bank has warned against further wage increase pressure and corporate pricing adjustments, thereby giving rise to broadening and self-fulfilling price rises. The substantial price hike of major electrical appliances, rarely seen in recent years, may be a sign of broadening inflation.

In short, the current rise in inflation in China has typical cost-push characteristics, reflecting the limitations to the growth pattern that counts on resources and cheap labour. This has also made China more susceptible to soaring global commodities prices, bringing about imported inflation as well. Therefore, lower U.S. rates and the weak dollar, as well as the impacts on commodities prices, would inevitably fuel China's inflation. The cost-push nature of current inflation would also make it less sensitive to economic cycles. The worst situation may be - while the economy cools down, inflation pressure remains.

Policy Alternatives

China has been encountering challenges of rising domestic inflationary pressure and global economic uncertainties in the past year, when attempting to prevent over-investment and overheating. Two policy guidelines can be identified. The first is the intention to prevent inflation and overheating, including the tightening of monetary policy. The second is to retain some flexibility so as to tackle external influences. Nevertheless, the practical measures are still uncertain. Yet, the following policy preferences can be expected.

Considering the risks mentioned above, the threat of inflation is real as well as pressing. As for external developments that may lead to over-cooling, it is a potential risk, depending on the U.S. economy. In other words, in contrast to U.S. policies, China has to focus on tackling inflation first. Early control of investment and credit would also prevent excess capacity from becoming too serious in case exports eventually slow. Therefore, it is expected the bias towards tightening would not alter in the first half-year or at least the first quarter.

Secondly, as the impact of the U.S. economic slowdown should not be neglected, it is expected the Chinese authorities would maintain a step-by-step approach in tightening. Besides, more specific measures are expected, for example fixed investments in the manufacturing industries that face higher risk of excess capacity would be main targets of cooling while infrastructures would receive more support. This represents supply side measures to tackle inflation and is particularly justified after the snow storm early this year.

Thirdly, interest rates and exchange rate should remain the major policy tools. Though rising interest rates has limited impact on food prices, it can correct the negative interest rate situation and contain inflationary expectations. Comparing the 1-year fixed deposit rate with CPI, there should be at least a half-point rate hike to close the negative interest rate gap. As China's financial markets remain basically closed, worry over attracting further capital inflow would probably not prevent additional rate hike. As for exchange rate policy, allowing further appreciation of the domestic currency should remain a tool against imported and cost-push inflation. This is expected to continue in the first half-year. Yet, taking into consideration the potential deterioration of exports, a one-off significant appreciation is still considered unlikely.

Su ZhiXin
Senior Economist